Feedback Effects and the Limits to Arbitrage
University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)
University of Pennsylvania - The Wharton School - Finance Department
Columbia Business School - Finance and Economics
June 22, 2012
ECGI - Finance Working Paper No. 318/2011
AFA 2013 San Diego Meetings Paper
This paper identifies a limit to arbitrage that arises because firm value is endogenous to the exploitation of arbitrage. Trading on private information reveals this information to managers and improves their real decisions, enhancing fundamental value. While this feedback effect increases the profitability of a long position, it reduces the profitability of a short position. Thus, investors may refrain from trading on negative information, and so bad news is incorporated more slowly into prices than good news. This has potentially important real consequences -- if negative information is not incorporated into prices, inefficient projects are not canceled, leading to overinvestment.
Number of Pages in PDF File: 37
Keywords: Limits to arbitrage, feedback effect, overinvestment
JEL Classification: G14, G34working papers series
Date posted: March 21, 2011 ; Last revised: June 23, 2012
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